How to tell if the profits are real

Don’t let the dream turn into a nightmare: a profitless business is no business at all.

By Andrew Kent

Potential owners, when reviewing businesses for sale, are looking for some assurance that this year’s income can be repeated or improved into the future. A starting point for this is evaluating whether the stated profits are real.

A potential owner reviewing the performance of a business over several years may be presented with a substantial difference between the current year’s earnings before interest and tax (EBIT) and figures for previous years.

They will need to determine the source of the difference: whether it is due to improved business performance or is a change in the way the finances have been accounted for.

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While Australia’s accounting standards have generally prevented the sort of creative accounting that is commonplace in China (for example amortising future earnings), this does not mean that the calculation of the EBIT or EBITDA (earnings before interest, tax, depreciation and amortisation) are not subject to adjustment depending on the primary audience.

As a general rule the two primary audiences of these figures are the owners themselves and the tax office. In these circumstances the owners are often prepared to see the numbers legally realigned to provide less revenue to the tax office.

However, when it comes time to sell, these numbers may not do justice to the business and subsequently devalue it, which is one of the reasons why preparing a business for sale can take a little longer than many people expect.

Typically, a privately owned business will have its financial affairs integrated with those of the individual owners, to minimise tax without exposing personal assets to business risk.

These structures can be quite complicated and need to be unravelled before selling the business. Once the business has been isolated in this way, its financial performance may appear to be very different from previous years.

The challenge for potential buyers is determining if the newly stated performance is genuine or whether other things need to be brought into consideration. For example, is the salary of the owner included in the profit figures or accounted for separately as a business cost.

You may need an accountant to determine what the real profit is, but it is important to understand that there may be a good reason for significant adjustments to reported profits, and if there is you may well have found your next accountant.

Either way, the key question to ask is: what are the comparable revenue, costs and margins over the last three to five years and how have they been accounted for? Only then will you know if the profits are real.

BizExchange has hundreds of genuine businesses listed for sale with separate fields for turnover, EBIT and key person salary to make it easier to see at a glance how profitable a business really is.